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Marco Onado . 8196 Comparative Financial Systems April 21, 2010 Large Complex Financial Institutions. Agenda. LCFI and systemic risk The characteristics of LCFI The contribution of LCFI to the crisis The debate on how to control systemic risk.

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marco onado

Marco Onado

8196 Comparative Financial Systems

April 21, 2010

Large Complex Financial Institutions

  • LCFI and systemic risk
  • The characteristics of LCFI
  • The contribution of LCFI to the crisis
  • The debate on how to control systemic risk
the economic literature on systemic instability
The economic literature on systemic instability
  • Empirical literature maintains that the level of banks’ exposure to systemic shocks tends to determine the extent and severity of a systemic crisis.
  • However, an individual bank can – through failure or inability to operate – also be a source of systemic risk.
  • The transmission channel of the idiosyncratic shock can be direct – for example if the bank was to default on its interbank liabilities – or indirect, whereby a bank’s default leads to serious liquidity problems in one or more financial markets are involved
a boe definition of lcfi paper 03 a central bank s perspective
A BoE definition of LCFI (paper 03) (a central bank’s perspective)
  • To join the group of LCFIs, a financial institution must feature in at least two of the following six league tables:
    • ten largest equity bookrunners world-wide
    • ten largest bond bookrunners world-wide
    • ten largest syndicated loans bookrunners world-wide
    • ten largest interest rate derivatives outstanding world-wide
    • ten highest FX revenues
    • ten largest holders of custody assets world-wide.
a few conclusions
A few conclusions
  • The importance of the presence in global financial markets
  • The global financial market means interconnections
  • Interconnection through otc markets means counterparty risk (the main cause of systemic effects)
  • Investment banks were
    • Leveraged
    • Financed through the repo market
the ecb dec06 identifying large and complex banking groups
The Ecb (dec06) : identifying large and complex banking groups
  • For the purposes of financial system stability assessment, it is important to identify and monitor the activities of banking groups whose size and nature of business is such that their failure and inability to operate would most likely have adverse implications for financial intermediation
  • Size is the first criterion, but it is not enough
the ecb definition
The ECB definition
  • Large and complex banking groups can be considered as institutions whose size and nature of business is such that their failure and inability to operate would most likely spread and have adverse implications for the smooth functioning of financial markets or other financial institutions operating within the system.
  • If the disturbance were large enough to threaten financial system stability it could be transmitted through various channels – including payment systems and markets – but would most likely originate from an institution being unable to meet its payment and settlement obligations.
banks considered by the ecb research
Banks considered by the Ecb research
  • Domiciled in Europe and with total assets in excess of one billion euro; or
  • Included in the top 30 bookrunners in the European equity, bond and syndicated lending markets; or
  • Among the top 48 worldwide custodian banks according to Global Custody.
indicators used by the ecb
Indicators used by the Ecb
  • Traditional banking balance sheet items: loans, mortgages, other earning assets, deposits and contingent liabilities;
  • Traditional indicators of banking activity: net interest revenue and net non-interest revenue;
  • Interbank assets and liabilities;
  • Bookrunner role: proceed amount in European equity, bond and syndicated loans markets; and
  • Custodian role: worldwide assets under custody.
Cumulative banking sector asset shares of the 25largest euro area banking groups (percentage of total assets)
interconnections are more important than size
Interconnections are more important than size
  • However, asset size alone may fail to shed much light on the importance and complexities of the interconnections that a banking group may have within a financial system, especially given the growing importance of banks’ off-balance sheet activities.
  • Knowledge about such interconnections is important because it can help in mapping how, or if, strains in a large banking group could spread to other institutions or markets.
the ecb conclusion
The Ecb conclusion
  • It should be emphasised that such banking groups are not necessarily those that are often called “systemically relevant institutions”.
  • Rather, they are banking groups whose size and nature of business is such that their failure and inability to operate would most likely have adverse – albeit not necessarily severe – implications for various forms of financial intermediation, the smooth functioning of financial markets or other financial institutions operating within the system.
the ecb conclusion1
The Ecb conclusion
  • As shown, the importance of a banking group in the financial system can go beyond traditional measures of size: the role it plays in specific banking activities, or the interconnections it has with other parts of the financial system
not all relevant information are publicly available
Not all relevant information are publicly available
  • Some of this information is publicly available, but there are important gaps in information – for example on the off-balance sheet positions of banks, the degree of their participation in relatively new financial markets (e.g. structured finance, traditional credit issuance, etc.), or on cross-border activities – that leave room for further refinement of the filtering procedure.
the turner report
The Turner Report
  • The origins of the current crisis entailed the development of a complex, highly leveraged and therefore risky variant of the securitised model of credit intermediation.
  • Large losses on structured credit and credit derivatives, arising in the trading books of banks and investment banks, directly impaired the capital position of individual banks, and because of uncertainty over the scale of the losses, created a crisis of confidence which produced severe liquidity strains across the entire system.
  • As a result, a wide range of banking institutions now suffer from an impaired ability to extend credit to the real economy, and have been recapitalised with large injections of taxpayer money.
the importance of proprietary trading from a systemic point of view from the turner review
The importanceofproprietary trading from a systemicpointofview (from the Turner Review)
  • Trading of complex instruments in dealing rooms by bankers who in the past have received very high remuneration is now resulting in significant economic harm.
  • The issue clearly posed, and now extensively debated, is whether future regulation shoul enforce a greater institutional separation between classic bank services to the real economy (sometimes labelled ‘narrow’ banking or ‘utility’ banking) and risky propriety trading activities (sometimes labelled ‘investment banking’ and sometimes ‘casino banking’).
big vs interconnected
Big vs interconnected
  • The degree to which individual banking groups are “large” in the sense that this could be a source of systemic risk would therefore seem to depend on the extent to which they can be a conduit for diffusing systemic and idiosyncratic shocks through a banking system.
size according to the group of thirty
Size according to the Group of Thirty
  • The notional balance sheet is a frequently used measure, but it is not in itself sufficient.
  • More refined measures would take into account a combination of on- and off-balance-sheet items, with appropriate risk weightings.
  • These metrics should then be viewed relative to the size of a country’s financial markets, banking system, and economy, with some individual institutions or national banking systems posing potential for problems that exceed a home country government’s support capacity.
leverage according to the group of thirty
Leverage according to the Group of Thirty
  • The scale of leverage being employed and the speed of potential liability contraction is a second important characteristic.
  • Large size alone is not a sufficient determinant of potential systemic risk, if that size is supported by a combination of permanent equity and a structure of liabilities consistent with asset characteristics.
  • It is the interaction of relatively illiquid risky assets and large amounts of short-term funding that creates the greatest potential for disruptive failures.
interconnectedness according to the grouo of thirty
Interconnectedness according to the Grouo of Thirty
  • Refers to the degree to which one financial firm’s potential failure will have immediate and sizeable knock-on effects on a large number of other significant financial institutions. In this regard, perhaps the two best systemic risk metrics are:
    • the scale (size) and scope (range of markets) of over-the-counter (OTC) derivative market contracts;
    • the largest gross and net collateral counterparty risk exposures to particular firms.
  • The lack of transparency in these markets—as contrasted with exchange-based clearinghouse arrangements— has made judging systemically significant degrees of interconnectedness particularly difficult
systemic significance of infrastructure services according to the group of thirty
Systemic Significance of Infrastructure Services according to the Group of Thirty
  • Certain types of infrastructure-like services provided by financial institutions to other such institutions are of systemic importance.
  • These include highly specialized custody, clearing, settlement, and payment services, and many of the services provided by prime brokers.
  • The nature of these services is such that they inevitably require large credit linkages between service providers and users, and changes in service relationships are operationally complex and time-consuming.
the group of thirty no rigid definition
The Group of Thirty: no rigid definition
  • In practice, it is some combination of these characteristics that make for a potential “systemically important” financial institution.
  • While these criteria can be defined in advance in general terms, it would not be sensible or prudent for regulators to define them with statistical precision or inflexibly.
  • Rather, a country’s prudential regulator—in cooperation with its central bank in those countries where these roles are separate—should have sufficient authority to set and modify criteria used to make these determinations.
  • The end result should be a basis for identifying firms that are likely to require potential regulatory intervention to manage the process of failure and hence also require more preventative oversight.
what interconnectedness mean an international approach
WhatinterconnectednessmeanAn internationalapproach

Nodes: 18 Major countries

Size of Nodes: Gross External Financial Stock

Thickness of the lines: Bilateral External Financial Stock relative to combined GDP

the imf on the dangers of interconnectedness
The IMF on the dangers of interconnectedness
  • The rise in the complexity and globalization of financial services has contributed to stronger interconnections or linkages.
  • While more extensive linkages contribute to economic growth by smoothing credit allocation and allowing greater risk diversification, they also increase the potential for disruptions to spread swiftly across markets and borders
  • In addition, financial complexity has enabled risk transfers that were not fully recognized by financialregulators or by institutions themselves, complicating the assessment of counterparty risk, risk management, and policy responses.
lcfi and the problem of the investment banking business
LCFI and the problem of the investment banking business
  • What happened to the investment banks
  • Are investment banks the main responsible of the crisis?
  • The modern investment bank: a new species?
  • Goldman Sachs and the Sec action for an alleged fraud
  • The current US Senate investigation (April 27th)
from a private partnership to the flotation in 1999 delayed by the lctm crisis
From a private partnership to the flotation in 1999 (delayed by the LCTM crisis)
  • Like most of its rivals, Goldman is a difficult institution for outsiders to understand. Until 1999 it was a private partnership. With public ownership came greater reporting responsibilities, but precisely what Goldman is up to remains obscure.
  • The bank likes to say that it still relies a lot on traditional investment banking, but Goldman's accounts show that its profits come increasingly from trading.
  • The sharp-suited investment bankers act as a sales force for less-well-dressed colleagues who work out how to make money from swaps, options and direct investments (see article).
the economist on goldman sachs
The Economist on Goldman Sachs

In its taste for risk, the world's leading investment bank epitomises the modern financial system

what bank is this
What bank is this?
  • By any measure, Goldman Sachs is a formidable company.
  • The bank knocks the spots off its competitors, whether in pure “investment banking”, the traditional craft of underwriting and mergers and acquisitions in which it made its name, or in its new focus, trading for customers and its own account.
  • Even compared with leaders in other industries, Goldman makes spectacular returns. Among its latest record-busting yardsticks was a 40% quarterly return on equity.
  • The average pay-packet of its 24,000 staff last year was $520,000—and that includes a lot of assistants and secretaries.
a new kind of intermediation
A new kind of intermediation…
  • The real reason why Goldman should matter to outsiders is not because it is a manufacturer of millionaires (good luck to it); but because it stands at the centre of a two-decade-long transformation of the financial markets and a new approach to risk
  • Business risks that were once seen as a lumpy fact of life are now routinely sliced up and packaged into combinations that generally suit issuers and investors alike. At the heart of the change has been the development of huge markets in swaps, derivatives and other complex and often opaque instruments that allow the transfer of risk from one party to another. From small beginnings in 1987, the face value of contracts in interest-rate and currency derivatives is now more than $200 trillion—16 times America's GDP. A further $17 trillion is outstanding in (even newer) credit-default swaps, which allow bond investors to lay off the risk of issuers defaulting.
based on generating instruments and trading them rather than lending
… based on generating instruments and trading them, rather than lending
  • Led by Goldman, investment banks have innovated at a furious pace and changed the mix of their own businesses. They have taken on more risk as they have moved from more transparent markets, in which margins are slim, to more profitable portfolios of derivatives and direct private-equity investments. The face value of Goldman's derivatives exposure is more than $1 trillion, although the bank says that its net exposure, once you offset all its positions, is $58 billion, against shareholders' funds of $28 billion. The bankers' innovations have brought huge rewards to their industry. In the past decade it has garnered revenues of more than $125 billion, more than three times the level in the previous decade.
the three big questions
The three big questions
  • How exactly has Goldman and its industry achieved this?
  • Can it be sustained?
  • What should happen if something goes wrong?
where do the profits come from
Where do the profits come from?
  • Back before Goldman went public in 1999, the firm was looked upon with a certain awe—a secretive, private partnership, the last truly large such entity in American finance, that consistently minted money without having to disclose anything.
  • In 2006, despite public filings that are so large they can be more easily measured in weight than in pages, Goldman Sachs remains just what it was in 1999, only more so: it is a hugely profitable enterprise—return on equity during the first quarter of this year approached 40%, notwithstanding a compensation scheme for employees that would make the old partners jealous; and it remains something of an enigma.
operational compliance and reputational risks are enormous
Operational, compliance and reputational risks are enormous
  • But for how long? The market doubts the run of huge profits can last. Goldman's shares are valued less richly than those of competitors it so obviously outwits. Moreover, investment banks are less highly valued than less glamorous commercial banks and retail brokerage firms.
  • This could be because investors think Goldman will struggle to sustain the breakneck innovation that keeps it ahead of others. Goldman's ascendancy is already showing stresses—most recently the struggle to manage conflicts of interests across its business lines.
what about the financial risk
What about the financial risk?
  • A bigger problem for both investors and regulators has to do with risk itself.
  • Outsiders—and perhaps even insiders—find it hard to judge whether Goldman's business is sustainably good or has thrived thanks to a dose of unsustainable good luck and skill.
  • In addition, the very improvements in risk management that have spread risk far and wide make it harder to know where risk is concentrated or how risks might combine to threaten the system's overall health
financial risk and central banks concerns
Financial risk and central banks concerns
  • So far central banks have concluded that the system is more robust than it was. But the trading models that have propelled Goldman will be tested one day. At worst, the bank itself—or, more likely, a second-tier rival or a hedge fund—might fall into the kind of dramatic spiral that killed off Long-Term Capital Management (LTCM), a hedge fund, in the late 1990s. Financial markets have always been subject to crises.
  • Any crisis would affect Goldman, because it is so intertwined with the system. The bank says it keeps plenty of liquid reserves against the dread day. It might well profit from any crisis (it did from LTCM). But the chances are that some banks, somewhere, will get into serious trouble.
economist leader s conclusion
Economist leader’s conclusion
  • Love Goldman or hateit, yououghttoadmireit and the system itepitomises. And hang on tight.
ml bofa on trading revenues
ML_BofA on trading revenues
  • FICC was yet again the bright spot, posting record revenues of $7.4bn, compared to the $5.0-5.5bn range reported by peers so far.
  • Jumped 33% vs. 4Q09 which was actually a normal, seasonal result